Abstract

The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") was enacted in July 2010. Dodd-Frank's preamble proclaims that one of the statute's primary purposes is to "end 'too big to fail' [and] to protect the American taxpayer by ending bailouts." Dodd-Frank does contain useful reforms, including potentially favorable alterations to the supervisory and resolution regimes for systemically important financial institutions ("SIFIs"). However, Dodd-Frank falls far short of the fundamental reforms that would be needed to eliminate (or at least greatly reduce) the public subsidies that are currently exploited by "too big to fail" ("TBTF") financial institutions.

After briefly describing the financial crisis that led to the enactment of Dodd-Frank, this article evaluates whether the new statute is likely to solve the TBTF problem. Dodd-Frank establishes a new umbrella oversight body – the Financial Stability Oversight Council – that will designate SIFIs and make recommendations for their regulation. The statute also authorizes the Federal Reserve Board ("FRB") to apply enhanced supervisory requirements to SIFIs. Most importantly, Dodd-Frank establishes a new systemic resolution regime – the Orderly Liquidation Authority ("OLA") – that should provide a superior alternative to the "bailout or bankruptcy" choice that federal regulators confronted when they dealt with failing SIFIs during the financial crisis.

Nevertheless, Dodd-Frank does not solve the TBTF problem. Congress did not adequately strengthen statutory limits on the ability of large complex financial institutions ("LCFIs") to grow through mergers and acquisitions. The enhanced prudential standards to be imposed on SIFIs under Dodd-Frank rely heavily on capital-based regulation, which has repeatedly failed to prevent financial crises in the past. Moreover, the success of Dodd-Frank's supervisory reforms will depend heavily on many of the same federal agencies that failed to stop excessive risk-taking by LCFIs in the past and, in the process, showed their vulnerability to political influence wielded by LCFIs and their trade associations.

Dodd-Frank's most promising reform – the OLA – does not completely close the door to future transactions that protect creditors of failing LCFIs. The FRB and the Federal Home Loan Banks retain authority to provide emergency liquidity assistance to troubled LCFIs. The FDIC can borrow from the Treasury and can also use the "systemic risk exception" to the Federal Deposit Insurance Act in order to generate funding to protect creditors of failed SIFIs and their subsidiary banks. While Dodd-Frank has made bailouts more difficult, the continued existence of these additional sources of financial assistance indicates that Dodd-Frank probably will not prevent TBTF rescues during future episodes of systemic financial distress.

Contrary to my earlier recommendation, Dodd-Frank does not require SIFIs to pay risk-based assessments to pre-fund the Orderly Liquidation Fund ("OLF"), which will cover the costs of resolving failed SIFIs. Instead, the OLF will be forced to borrow the necessary funds in the first instance from the Treasury (i.e., the taxpayers). Dodd-Frank also does not include my previous proposal for a strict regime of structural separation between SIFI-owned banks and their nonbank affiliates. Thus, unlike Dodd-Frank, my earlier proposals would (i) require SIFIs to internalize the potential costs of their activities by paying risk-based premiums to pre-fund the OLF, and (ii) prevent SIFI-owned banks from transferring their safety net subsidies to their nonbank affiliates.

In combination, my proposals would strip away many of the public subsidies currently exploited by financial conglomerates and would subject them to the same type of market discipline that investors have applied over the past three decades in breaking up inefficient commercial and industrial conglomerates. Financial conglomerates have never demonstrated their ability to provide beneficial services to customers and attractive returns to investors without relying on federal safety net subsidies during good times and taxpayer-financed bailouts during crises. Congress must remove those subsidies and create a true “market test” for LCFIs, in which case market forces would probably compel many LCFIs to break up voluntarily.